International Finance Lecture 3: Exchange rate regimes Read: Chapters 2 Aaron Smallwood Ph.D.

IMF Classification of Exchange Rate Regimes Independent floating Managed floating Exchange rate systems with crawling bands Crawling peg systems Pegged exchange rate systems within horizontal bands Conventional pegs Currency board Exchange rate systems with no separate legal tender

Independent Floating Exchange rate determined by market forces, with intervention aimed at minimizing volatility: Example: United States

Managed Floating There is no pre-announced path for the exchange rate, although intervention is common. Policy makers will try to influence the “level” of the exchange rate: example: India

Crawling Band The currency is maintained within bands around a central target for the domestic currency against another currency (or group of currencies). The bands themselves are periodically adjusted, sometimes in response to changes in economic indicators. Example: Costa Rica, Mexico in 1994.

Example: Belarus through Feb 2008

Crawling pegs The domestic currency is pegged to another currency or basket of currencies at an established target rate. The target rate is periodically adjusted, perhaps in response to changing economic indicators. Example: Bolivia, China China allows for a daily revaluation of the RMB against a basket of currencies.

Birr/$ between Apr 10 and Apr 11

Exchange rates within horizontal bands The domestic currency is pegged to another currency or group of currencies. The exchange rate is maintained within bands that are wider than 1% of the established target: Example: Any ERM II country, including Denmark

Conventional pegs The country pegs its currency at a fixed rate to another currency (or group of currencies). The currency cannot fluctuate by more than 1% relative to the established target: Example: Saudi Arabia, formerly China

Currency boards Currency board countries are sometimes called “hard peggers”. Example: Hong Kong…. The currency board is a separate government institution whose only responsibility is to buy and sell foreign currency at an established price. The country will typically maintain foreign currency reserves equivalent to 100% of the total amount of outstanding domestic money and credit.

Hong Kong Jim Rogers a famed currency trader has noted: “If I were the Hong Kong government, I would abolish the Hong Kong dollar. There's no reason for the Hong Kong dollar. It's a historical anomaly and I don't know why it exists anymore…. You have a gigantic neighbor who is becoming the most incredible economy in the world.”

No separate legal tender The country uses another country’s (or group of countries’) currency as its own: Example: Ecuador (US dollar)

Benefits of pegging your currency Exchange rates are stable Could possibly benefit trade If pegged to a country with stable inflation, we may be able to import stable inflation. Likely provides an anchor for future inflation.

Drawbacks Loss of monetary policy independence Loss of the exchange rate as an automatic adjustment mechanism following economic shocks. Potential for major currency crises, especially if the trillema is violated.

Trillema The trillema, also known as the “impossible trinity” states that a country can ONLY have TWO of the following three: Fixed exchange rate system Free flow of capital Independent monetary policy.

Integration in Europe Integration in Europe begins with the ECSC in 1951. With the Treaty of Rome, the ECSC, EUROTOM, and the EEC are formed, which eventually are absorbed into the EU in 1994. ESCS leads to EEC, which leads to EC, which leads to the EU. Monetary integration is formalized with the establishment of the EMS where exchange rates are fixed. The mechanism by which exchange rates are fixes is known as the exchange rate mechanism. The EMS leads to European Monetary Union. The 17 countries that use the euro are part of a currency union known as the EMU. Monetary policy for the entire EMU is overseen by the European Central Bank in Frankfurt.

The EU and the EMU. EU Countries Today, there are 27 EU countries. The European Union is a political and economic union based on free trade. NOT ALL countries use the euro. There are several distinct groups EU Countries EU countries who are not in the ERMII and have no intention of adopting the euro EU Countries that will adopt ERM II countr(y)ies that have no stated intentions of adopting the euro ERM II countries that will adopt EMU Countries

Euro Area EU Austria Denmark Belgium Latvia Cyprus Lithuania Estonia Finland France Germany Greece Bulgaria Ireland Czech Republic Italy Hungary Luxembourg Poland Malta Romania Netherlands Portugal Sweden Slovenia UK Spain Slovakia Cyprus, Denmark, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia, Sweden and the United Kingdom are members of the EU but are not currently participating in the single currency. Denmark is a member of the Exchange Rate Mechanism II (ERM II). This means that the Danish krone is linked to the euro, but the exchange rate is not fixed. This map is used with permission

EU countries that are not part of the ERMII EU countries that will eventually adopt (or plan to): Bulgaria Czech Republic Hungary Poland Romania EU countries (not part of ERMII) with no stated intention of adopting the euro Sweden UK

ERM II Countries That will adopt: Latvia Lithuania The have no stated intentions of adopting Denmark

EMU Countries Austria (in 1999) - Netherlands (in 1999) - Portugal (in 1999) Belgium (in 1999) - Slovenia (in 2007) Cyprus (in 2008) - Slovakia (in 2009) Estonia (in 2011) - Spain (in 1999) Finland (in 1999) France (in 1999) Germany (in 1999) Greece (in 2000) Ireland (in 1999) Italy (in 1999) Luxembourg (in 1999) Malta (in 2008)

Is the EMU an OCA? OCA optimum currency area: The best geographic region where one currency is used within the region, and where outside the region, different currency(ies) are used. It is generally accepted that within an OCA: Countries should be relatively buffered from asymmetric shocks Factors of production should be mobile

Debt crisis On April 27 ,2010, Greece sovereign debt is downgraded to “junk” status by Standard & Poors. Facing a strong probability of default, the EMU and IMF approve a €110 billion rescue package for Greece on May 2, 2010. In May 2010, the European Financial Stability Facilty is formed. In conjunction with the IMF, up to €750 billion is available for countries potentially facing a crisis. In Ireland, the Anglo-Irish Bank is effectively nationalized in December 2008. On November 21, 2010, Ireland reaches an agreement for a bailout. On March 30, 2011, Ireland announces that it will need an additional €24 billion from the IMF and EFSF to aid ailing banks. The total bailout for Ireland has reached €70 billion. The Portuguese government released figures on March 30, 2011, indicating that the deficit had reached 8.6% of GDP. On April 6, 2011, the Portuguese government asks the EMU for a bailout.

Debt crisis continued (2011) July 2: A compromise is reached so that an installment of the €110 billion can be made. European leaders call on private bondholders to contribute to the bailout. July 21: A new bailout is approved for Greece. Originally valued at €109 billion, the totally has recently increased to €130 billion. August 7: The ECB begins to actively intervene to aid bond markets in PIIGS countries. October 26: In a summit of EU leaders, a grand plan is put together, where bondholders indeed agree to take up to 50% losses on holdings of Greek debt. As a result of severe political pressure, prime ministers George Papandreou (Greece) and Silvio Berlusconi (Italy) resign in November.

Debt crisis continued December 9: In a summit in Brussels, an intergovernmental treaty is agreed to, which among other things, cements more rigid rules for broaching thresholds on deficit and debt to GDP levels. December 21: The ECB announces that it will provide€489 billion in three-year loans to more than 500 banks in the EMU. As of January 4, 2012, with Italian sovereign debt hovering around 7%, the dollar price of the euro is $1.2923.

Major currency crises EMS crises of 1992-93. Following German re-unification contractionary monetary policy caused the currencies of German trading partners to become overvalued. Mexican peso crisis 1994-95. An overvalued exchange rate, policy mistakes, and political turmoil led to collapse of the peso, a severe recession and inflation before an IMF and US led bailout. Asian currency crisis (1997-98) Contagion Argentina (2001-02) Failure to use fiscal restraint and inflexibility in labor markets led to the collapse in this board system.

Overvalued/Undervalued? How would we know if a currency was overvalued or undervalued? Most economists use “real exchange rates”. According to the law of the one price:

Real Exchange Rate The real exchange rate is defined as: Take Mexico as an example: Suppose St is relatively stable but, PtMex increases much more rapidly than PtUS. The result, Rt increases. The Mexican peso appreciates in real terms.

Real Exchange rate If a country’s real exchange rate rises, some combination of the following three are occurring: The nominal exchange rate is appreciating Domestic prices are rising rapidly Foreign prices are falling. ALL THREE LIKELY LEAD TO A DECLINE IN THE DEMAND FOR EXPORTS

The Asian currency crisis On July 2, 1997, Thai Baht is devalued. July 11 Philippines devalues the peso July 14: Malaysia floats the ringgit July 17: Singapore devalues August 14: Thailand moves to a float October 14: Taiwan devalues November 14: Korea floats August 17, 1998: Russia abandons its peg Hong Kong: At one point, Hong Kong monetary authority raises rates to 500%.

Asian currency preview: The causes Liberalization of capital markets in a weak domestic financial environment. Crony capitalism Surge in risky real estate investment Maturity mismatch Secondary cause: Over-valued real exchange rates.